How to Choose the Best Investments for Your 401k Plan

Employer-sponsored 401k plans are one of the best benefits available to employees. Because the money you contribute is deducted from your gross income before taxes are incurred, you’re not taxed on the money you put in. The principal within the fund continues to grow on a tax-deferred basis until you receive distributions, and many employers contribute extra funds to your contribution, what some term “free money.”

For example, some employers contribute up to 6% of an employee’s salary on a dollar-for-dollar basis, up to the amount of the employee’s contribution. If you make $50,000 per year and set aside 10% of your salary into your 401k ($5,000), in this scenario your employer would contribute an additional $3,000 (6% of $50,000), increasing your total investment to $8,000. This is a major benefit that substantially accelerates capital growth.

Investing $5,000 per year for 20 years with a 5% growth rate results in a fund of $104,493; investing $8,000 over the same period at the same return produces a fund of $167,188. The ending balance is a combination of the money you invest and the rate of return you earn on your investment over time. With that in mind, you should work to maximize your contributions – including your employer’s matching contribution – by selecting the investments that will help you achieve your retirement goals.

Tips for Choosing the Best 401k Investments

Determining which investments are the “best” investments is not a “one size fits all” endeavor. Everyone starts saving at different ages, with different goals, different incomes and expenses, and varied retirement expectations. All of these factors affect which investments are most likely to fit your particular needs. Your decision may be further complicated by the investment options made available to you by your employer.

By law, 401k plans that allow you to select your own investments must offer at least three diversified options, each with different risks and returns. Generally, you’re not allowed to invest in collectibles, such as art, antiques, gems, or coins, but may under certain circumstances invest in a precious metal, such as gold. These are not usually recommended for retirement plans since they don’t earn a standard return, but fluctuate in price based on investor psychology and industrial value.

1. Your Investment Level

At a minimum, you should invest at least to the level of your employer’s matching contribution. In 2014, you can contribute up to $17,500 (or $23,000 if you’re 50 or older), with a maximum contribution of $52,000 (including the combination of your contribution and that of your employer). Most people find it easiest to break annual contributions into equal parts deducted each pay period. For instance, if you want to contribute $12,000 a year, you would request to have $1,000 deducted from your salary each month.

The best advice for anyone saving for retirement is to invest early and often. Saving early in life maximizes the benefit of tax-free compounding. Consider the example of Mike and Tom:

Both Mike and Tom earn the same 5% interest rate on their investments each year. Mike starts saving $200 a month in his company’s 401k plan at age 25, with an additional $100 per month contributed by his employer, for a total of $3,600 per year. Over the course of a 40 year career, he contributes $96,000 to his retirement plan. By age 65, Mike’s balance grows to $468,636.

Tom, on the other hand, waits until he’s 45 to begin saving in his employer plan. He contributes $400 per month, with a $200 match by his employer, for a total contribution of $7,200 annually. While Tom contributes the same total amount as Mike – $96,000 – his investment only has 20 years to grow. When he retires at age 65, his total investment is only $250,923, an amount roughly half of Mike’s final balance.

Your final balance is the sum total of the money you invest, your earning rate, and the time your investment is allowed to grow. Saving more and longer reduces the amount of earnings you must achieve to reach your final goal. As the rate of earnings decreases, the amount of risk needed to capture that earning rate also decreases, expanding the investment choices you have available to you.